Ch 1 Intro to Risk

Question 1

SLIDE: Benchmarks should be (6)

Answer 1

Benchmarks should be: 
1. transparent
2. timely
3. investible
4. objective
5. replicable
6 generally accepted
(true of most eq b/ms, FI less transparent.  Hedge funds often measured against return/vol targets based on peers)

Question 2

Standard Deviation

- Why

Answer 2

STandard Deviation

- CLT symmetry is appealing

Question 3

Downside risk

• LPM (2,t) (lower partial moment)
• LPM (0,t)
• LPM (1,t)

Answer 3

Downside risk

• LPM (2,t): semi-variance, or variance just on the downside
• LPM (0,t): not great as utility function; no curvature
• LPM (1,t): not great as utility function; no curvature
• all LPM with a>1 are risk averse investors. The higher the value the more risk averse.

Question 4

Downside Risk

- VaR and Conditional VaR

Answer 4

Downside Risk

- VaR and Conditional VaR: similar to LPM

Question 5

Upside Potential & Ratio Ratio

• UPR analogous to:
• Regret:

Answer 5

Upside Potential & Ratio Ratio

• UPR analogous to: Sharpe ratio
• Regret: return target in excess of benchmark

Question 6

Risk Budgeting (4)

Answer 6

1. Risk budgeting divides aggregate portfolio risk into sub-portfolios
2. By constraining risk at the sub-portfolio level fund can measure and control risk through the hierarchy
3. Mandates often reference a max and usual level of risk, as well as other risk control measures (max position size, permittable investments etc.)
4. Investment managers usually assessed against mandate limits daily by custodians

Question 7

Dimensions of Portfolio Risk

1. Investment Objectives
2. Investment Processes

Answer 7

1. Objectives: maximise returns subject to specific constraints
2. Processes:
   Policy, Objectives, How Achieve, Why
   Strategy: Mechanisms to achieve policy,
   Tactics: How to implement
   Liabilities
3. Other
   Liabilities - eg CF, min retirement requirement
   Risk: Risk Appetite Statement (idenitfy, plan for RM, regular assessment of processes

Question 8

Review of Case Study (eg GIC)
Identify
- Participant
- Role
- Risks
- Control
eg - GIC Board
OTHER participant examples

Answer 8

• Participant : GIC Board
• Role: Oversight
• Risks: legal, fraud, perfomance, counterparty, operational
• Control: governance, Risk Control framework, risk strategy and appetite, audits by external parties, management controls

Participants: Singapore Govt, Regulators, Board, asset consultant, Manager Researcher, Active Manager,

Question 9

Downside Risk

LPM formula

Answer 9

LPM (a,t) = 1/K SUM 1 to K max (0, t - R(t))^a

K = # scenarios, T = indiv scenario, t = target return, a = exponent, risk aversion

Question 10

Conditional shortfall:

• define
• define in terms of LPM

Answer 10

Conditional shortfall: when we fall below target, how far on average are we below

Conditional shortfall = LPM1 / LPM0

Question 11

How to calculate downside deviation

Answer 11

1. Define the minimum (eg 0)
2. Subtract the minimum return from each period return
3. After subtracting, if the return remains positive then reset the value to zero.
4. Square the differences and add the numbers together.
5. Divide by number of periods then take the square root. Sum all the numbers; divide by n
6. If downside volatility is lower than the SD; this is good, because it means downside volatility of (revenue stream) is lower than overall volatility.

Question 12

Upside Potential and Upside Potential Ratio

1. Formula
2. UPR analogous to:

Answer 12

UP(t)=∑▒〖max(0,R_i-t) p_i 〗
UPR(t)=(UP(t))⁄(Semi Deviation(t))
t = target return
pi = probability of scenario i
ri = return for scenario i

UPR is analogous to the Sharpe ratio – Upside return/upside risk